Are You Ready for Your Annual Audit?

It’s that time of the year again!  There are some best practices to follow to avoid pitfalls and issues while undergoing your year-end audit. Implementing these best practices should both enhance the value your organization receives from the audit process and help you comfortably meet your deadline for distributing audited financial statements to your investors and other users.  

It is management’s responsibility to prepare financial statements and to design, implement, and maintain internal controls relevant to the preparation and fair presentation of financial statements.  Management’s first step is to have an in-house accounting team capable of achieving effective financial reporting which enables management to prepare financial statements that are fairly presented.  While management can alternatively outsource the accounting function to a third-party service provider (for example, an external fund administrator) who can assist with preparation of the financial statements, it is important to keep in mind that management retains responsibility for the financial statements. 

If you haven’t already set up a planning meeting with your auditor, set it up now to discuss and provide an update to your auditor about what has occurred during the year.  Matters of interest to your auditor include amendments to the partnership agreement and other fund documents, capital activity, fund performance, any new or private investments, and any other notable changes that occurred in your operations and/or internal controls during the year.  Expected timing of audit fieldwork and audit completion should also be discussed at the audit planning meeting. If you have outsourced your accounting function to an external fund administrator, plan ahead so the expected timing fits into their schedule. 

 

Ask your auditors if they are aware of any new accounting pronouncements that are applicable to you that you should consider while preparing your annual financial statements. For example, Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASC 326), is effective for calendar-year privately held companies as of January 1, 2023. This standard replaced the incurred loss methodology with an expected loss methodology that is referred to as the current expected credit loss (“CECL”) methodology. The measurement of expected credit losses under the CECL methodology is applicable to financial assets measured at amortized cost.  Accordingly, while CECL is not expected to significantly impact investment funds that report substantially all of their assets at fair value, it will impact the evaluation of the collectability of accounts receivable in reporting entities such as investment management firms and broker-dealers.

 

In addition, FASB issued ASU No. 2022-03 in June 2022 clarifying fair value measurement of an equity security subject to contractual restrictions that prohibit the sale of an equity security. Certain new disclosure requirements were also introduced by ASU 2022-03. These updates are effective for fiscal years beginning after December 15, 2023, for public entities and fiscal years beginning after December 15, 2024, for other entities.

It is a standard practice for auditors to provide their clients with a list of items they will need to get the audit rolling (also known as the PBC or “Prepared by Client” list). Ask your auditor to provide this list well in advance of your fiscal year-end. Knowing ahead of time about some of the schedules and documents your auditors are going to need will help you keep these items in mind when you are going through the process of your year-end close. Share the list with your external fund administrator and agree on the expected timing of any audit schedules that they can help prepare. Carefully consider each of the schedules you may be preparing for the auditors. If any of them are considerably time-consuming for you or your external fund administrator to prepare, ask the auditors to explain why they need them. It is possible that they could get the same information from another resource.

 

For continuing or repeat audits, it is worth saving copies of the current-year schedules and documents you’ve submitted to your auditor for future reference. Make a note of the source within your accounting system, and the methods you have used, to extract specific customized reports that were part of the auditor’s current-year request list. In absence of significant changes in your business or operations, your auditor will most likely request those specific customized reports on an annual basis. Revisiting your notes from the prior-year audit will reduce your efforts in extracting those reports in the current year. This step is particularly helpful if you have had turnover in your accounting department and a new employee has taken over the responsibility of preparing and submitting information to your auditors. 

Before providing any of the requested schedules, documents, or back up to your auditor, check to make sure that the information agrees with your trial balance and/or internally prepared financial statements.  As an example, if you provide a schedule of partner contributions and withdrawals that does not reconcile to the corresponding amounts recorded in your trial balance, you will have opened up a whole can of worms. Even if you ultimately end up providing a corrected schedule that agrees to the trial balance, your auditors will want to know what changed and the reasons for the mismatch.  Any errors and/or reconciliations during the audit process add to the cost of the audit. Reviewing the audit schedules in advance can save you time during the audit and helps everyone focus on more important issues.    

The audit schedules that you submit to your auditors provide a good data point for them to begin their audit.  The auditors will have additional questions and most likely need to talk to you and/or your external fund administrator throughout the audit process.  Designating an individual to handle all audit-related requests and to provide timely responses to all their questions will improve the prospects of an efficient audit.  A weekly or bi-weekly audit status meeting between management and auditors provides touch points to discuss progress and resolve any issues identified during the audit.   

It is standard procedure for auditors to request confirmations from banks on account balances on all significant cash accounts. Other audit areas involving the confirmation process include investments and cash held at a qualified custodian, private investments (whether or not held at a qualified custodian), and capital activity including contributions, withdrawals, and transfers of interests.  Auditors are required to transmit the confirmation requests themselves directly to the bank, custodian or investor and, in turn, the auditors must receive the confirmation reply directly from those parties in order for it to be valid.  When inaccurate balances or incorrect information are provided on the audit confirmation, someone has to spend the time following up to get corrected information.  The best chance at improving the accuracy of your confirmations is to prepare them as close to the confirmation date as possible.  So, if your auditor needs a confirmation as of December 31, make sure that you have either signed any paper confirmations, or given electronic approval before this date.  The approved confirmation requests need to go out in the first week of January or as close to the year-end as possible.  

Auditors are required to include some element of “surprise” in their audit, so they are unable to tell you in advance absolutely everything that they plan to test. However, you can ask if there are any tests or testing selections that can be done ahead of time. Most accounting firms perform interim work covering transactions occurring in the first three quarters of the year. Purchase and sale of investments, realized gains and losses on sale of investments, valuation of private investments, and capital activity are the most common audit areas that get covered during interim. Interim procedures help avoid surprises at year-end as they provide your independent auditor an opportunity to look at your accounting records and provide recommendations way before the chaos of year-end hits you.  

Valuation of private investments (referred to as level 3 investments) is of critical importance to investors and is often an area that is closely looked at by auditors and their valuation specialists due to the measurement uncertainty and degree of judgment inherent in valuing such investments. 

 

Most auditors expect management to prepare a comprehensive year-end valuation package for all private investments. The valuation package should provide a comprehensive write-up for each private investment being valued, including references to applicable support and documentation included within the valuation package. Clearly explain within the valuation package your rationale for any specific factors such as discounts due to lack of marketability or lack of control inputs. Providing rationale for any changes in valuation methodology or inputs that have changed from prior valuation periods helps avoid follow-up questions from your auditors. 

 

Management can utilize the accounting and valuation guide published by the American Institute of Certified Public Accountants (“AICPA”) as a resource while preparing their private investments valuation package. This guide provides guidance and illustrations for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments of venture capital funds, private equity funds and other investment companies. The goal of the AICPA’s guide is to provide user-friendly guidance with case studies that can be used to reason through real-life situations faced by fund managers.

On August 23, 2023, the SEC adopted the amended Private Fund Advisers Rule. Among other matters, the amended rules require registered private fund advisers to cause each private fund they advise to undergo an annual financial statement audit that meets the requirements of the audit provision in the Advisers Act rule 206(4)-2. Previously, registered private fund advisers could comply with rule 206(4)-2 either through a financial statement audit of each private fund or, subject to meeting certain conditions, could engage an independent public accountant to verify funds and securities at least once during each calendar year (a so-called “surprise exam”). The amended rules remove the option of engaging an independent accountant to perform a surprise exam with respect to client funds and securities held in pooled investment vehicles. The amended rules provide for an 18-month transition period for all private fund advisers for compliance with the Audit Rule. Registered private fund advisers should consult their legal counsel to ensure compliance with the amended Private Fund Advisers Rule.  

Preparation for a successful annual audit requires ongoing efforts from management to establish and maintain a financial reporting system that is capable of generating accurate and reliable financial information throughout the period covered by the audit. The audit process is a two-way street requiring management and their auditors to fulfil their respective responsibilities. Plan ahead and implement best practices discussed above for a successful annual audit.